# Week04: Logic of Financial Statements

### Week04: Logic of Financial Statements

#### Summaries

• week04_Logic of Financial Statements > 4.1 The Relationship Between Balance Sheet and Income Statement > New Unit
• week04_Logic of Financial Statements > 4.2 Getting to Know Cash Flow Statement > New Unit
• week04_Logic of Financial Statements > 4.3 The Function of Cash Flow Statement > New Unit
• week04_Logic of Financial Statements > 4.4 The Generation of Cash Flow Statement > New Unit
• week04_Logic of Financial Statements > 4.5 The Logic of Financial Statements > New Unit
• week04_Logic of Financial Statements > 4.6 Roles of the Three Statements > New Unit

#### week04_Logic of Financial Statements > 4.1 The Relationship Between Balance Sheet and Income Statement > New Unit

• Until now, we have gotten an even better understanding of what balance sheet and income statement are.
• Through the process of learning how to state the 13 business activities on the financial reports, we learned how business activities can affect financial reporting In earlier discussions of balance sheets and income statements, we discovered they have a really close relationship.
• The funnel shaped one on the right side is the income statement.
• Shareholders decide to distribute ￥1 million in dividends, so the company will have ￥4.2 million retained earnings.
• The ￥4.2 million retained earnings can be considered as continued investment from shareholders.
• We can see here, the ￥4.2 million is added to Retained Earnings on the balance sheet.
• Therefore income statement is based on a period of time So we have a financial report at a certain point in time and the other report based on a period of time.
• We got a ￥5.2 million net income.
• So we are left with ￥4.2 million If the company had ￥10 million retained earnings by 12/31/2011, what will it be by 12/31/2012? The answer is ￥14.
• As we can see here, retained earnings are actually the most direct bridge connecting the balance sheet and the income statement.
• This is a connection between balance sheet and income statement, but it is a really apparent connection.

#### week04_Logic of Financial Statements > 4.2 Getting to Know Cash Flow Statement > New Unit

• Does anyone remember what the third financial report is? It is the cash flow statement.
• Cash flow seems to be the most complex one of the reports, Why? because it is really long and include the primary table and appendix two parts.
• Even though cash flow statements look the most complex, it is actually the easiest financial report.
• How is this so? First, let’s talk about what is cash flow.
• Cash flow is such an simple concept that everyone can understand easily.
• Since it is called flow, it must contain inflow and outflow.
• What is cash inflow? Obviously, it means the money I received.
• What is cash outflow? Cash outflow is the money I spent.
• So what does cash flow statement indicate? It tells me how much money I receive and spend.
• If you know how to make journal entries, you can do cash flow statements as well.
• Why? It is because making cash flow statements is just like writing down journal entries.
• So what is the difference between these two? The only difference is we sort business activities into 3 different categories in cash flow statements.
• How to make a cash flow statement? We will classify cash inflows and outflows based on these three categories.
• How come? For example, if I get paid today, what kind of cash flow is this? Which kind of business activity? It is my operating activity, but is it a cash inflow or outflow? It is a cash inflow.
• This is an outflow as well So it is an operating cash outflow.
• The wages I paid to this person are also an operating cash outflow.
• What is the tax you paid? It also belongs to operating cash outflows.
• What if I sold my house or car, I will receive cash inflows.
• What is this kind of activity? It belongs to the investing cash inflows.
• What if I got a loan when I purchase the house? What is the activity of getting loans? This is a financing cash inflow.
• The expenses related to the loan are financing cash outflows.
• What cash inflow or outflow do they have? Let’s take a look.
• Similar to personal life, as a company our first operating cash inflow is from sales.
• When we sell something, we will generally receive cash sooner or later.
• If I pay salaries to my employees, the salaries are also operating cash outflow.
• The tax expenses belong to operating cash outflow as well.
• What is this? How can tax become a cash inflow? We may come up with a lot of different explanation.
• If they lease a house from someone else, they will need to pay rent which is a cash outflow.
• If the company rent a spare room out, then they will have cash inflows from collecting rent.
• No matter the investment is in or outside of the company, the money spent is investing cash outflows.
• What will lead to the investing cash inflow? There are two possible explanations.
• The sales of buildings, equipments, machines, vehicles, or the sales of the stock of the companies I invested, all of these will bring cash inflows.
• We will still have some other kinds of cash inflow besides these.
• What is this for me? It is a return on my investment; the return will also bring me a cash inflow.
• Last but not least, let’s take a look on financing cash flows.
• No matter issuing debt or stock, they will both bring cash inflows.
• If a company issues stock, it may need to distribute dividends as well, cash outflow for interest payment belongs to operating cashflow).
• There are also some other activities will change financing cash inflow.
• The payment of the rents is a financing cash outflow.
• These are the basic content of a cash flow statement for a company, but what does cash flow statements tell us? Let’s continue.

#### week04_Logic of Financial Statements > 4.3 The Function of Cash Flow Statement > New Unit

• We know that a cash flow statement is in fact the description of our cash inflows and outflows according to three activities that the company engages in, namely operating, investing, and financing activities.
• What is the significance of such a description? We all know that cash inflows make our cash increase while cash outflows make our cash decrease.
• Obviously, on the Cash Flow Statement, I add up all my cash inflows and all my cash outflows respectively, and then subtract the two of them, what can I get? It is our net cash flow.
• What is the first point? It is that Cash Flow Statement is not actually needed if we only want to know the change in cash flow, because the information could be get from another statement.
• There is an item on Balance sheet called cash and cash equivalent.
• What does the Cash Flow Statement tell us? It tells you the inflow and outflow of capital and the distribution in operating, investing, and financing activities.
• If we use one sentence to describe the function of Cash Flow Statement, we can say that it tells you how the amount of your cash increases or decreases and why it happens? Or we can say that it tells the cause and effect of your cash flow.
• Why should we know the cause and effect of the cash flow? Why it is of totally different significance to us for different inner distribution of a net cash flow of 10 million.
• They spend 80 million in investment activities and 10 million in financing activities, so the net cash flow is 10 million.
• We need a Cash Flow Statement to tell us the reason for the amount of increase or decrease in cash.
• What is it? If the Cash Flow Statement describes one item on the Balance sheet, what item it is? It is the item of cash and cash equivalent.
• The Cash Flow Statement shows the reason for the increase or decrease of the cash.
• Then will you think of another question? There are so many items on the Balance sheet, why don’t we make statement for each single item to show the reason for its change? Why is the item cash singled out? There must be some difference between the item cash and other items.
• From this point, why is it necessary for us to use the Cash Flow Statement to describe the cause and effect of the change of cash? Because we care about the survival of the enterprise.
• What does the Cash Flow Statement tell us? In one sentence, it tells us the cause and effect of the change of cash.
• Have you ever thought of the question that if it is the meaning of Cash Flow Statement, we have already seen the process for making balance sheet and income statement, do you also want to know how is the Cash Flow Statement made? It will be discussed in the following episode.

#### week04_Logic of Financial Statements > 4.4 The Generation of Cash Flow Statement > New Unit

• We have learned the form and function of Cash Flow Statement.
• Just now we have discussed the process for the making of Balance sheet and income statement You might wonder how is Cash Flow Statement made.
• We will use the example for discussing Balance sheet and income statement Suppose there is a newly started company In the first year there were a total of 13 economic activities We discussed each of the activity in order to understand how these activities influence the statements of the company After discussing all of the 13 economic activitieswe helped.
• If we reflect on the example we will find that all of the 13 economic activities involve in the receiving and expenditure of cash.
• Why Because all of the 13 economic activities are related to the increase or decrease of cash.
• What is itWe are going to define each of them as operating activity investment activity or financing activity.
• In the third economic activity the company spent 57 million to purchase the fixed assets like plant building equipments and so on.

#### week04_Logic of Financial Statements > 4.5 The Logic of Financial Statements > New Unit

• If the three financial statements could describe all economic activities of enterprises accurately then we can understand the necessity of making them.
• In the example there were 13 economic activities in the first year after the establishment of the company Let’s review these activities There are financing activities covering debt financing and equity financing investing activities and operating activities.
• The operating activities involve procurement manufacturing R&D management and so on.
• So we can say although there are merely 13 economic activities it reveals the real condition of a company.
• In other words it covers all economic activities of a normal operating company Then how are the 13 economic activities reflected on the financial reports of the company.
• Let’s look at the income statement first Among the 13 economic activities which one appeared first on the income statement.
• All the activities happened before that including raising money construction of manufacturing facilities procurement of raw materials and manufacturing.

#### week04_Logic of Financial Statements > 4.6 Roles of the Three Statements > New Unit

• Just now we said that the three financial statements constitute an integral whole.
• Mean while each of them has its responsibilities Income statement mainly describes operating activities.
• Balance sheet focuses on investing and financing activities.
• Cash flow statement tells us the risk condition So they constitute an integrated one.
• They complement one another to form a complete description of a company.
• For example Suppose I want to get loan from banks which financial statement do you think the bank concerns the mostIs it the income statement the balance sheet or the cash flow statement.
• You may choose the balance sheet Why Because balance sheet tells what the company actually have so if the company cannot repay the debt they can use what the company have on the balance sheet to repay the debts.